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India announces policy for strategic partnerships in the defence sector

On 31 May 2017, the Ministry of Defence (MoD) notified Chapter VII of the Defence Procurement Procedure, 2016 (DPP 2016) on strategic partnership. Although defence manufacturing has been open to private sector participation for well over a decade, grievances have been aired in relation to the lack of a level playing field in comparison to defence public sector undertakings (DPSUs) and Ordnance Factory Boards (OFBs), which are favoured by the Government in respect of long-term purchase arrangements for major defence platforms and equipment such as aircrafts, submarines, helicopters and armoured vehicles. The strategic partnership construct is significant as it seeks to assuage the grievances of the private sector and envisages a partnership structure to enhance competition, increase efficiencies, facilitate faster absorption of technology, create a tiered industrial ecosystem and promote participation in global value chains including exports.

In this article, some of the salient features of the strategic partnership model are examined. For this purpose, our analysis is divided into the following broad categories.

Part A: In this section, we examine the process of shortlisting both domestic Strategic Partners (SPs) and potential foreign original equipment manufacturers (OEMs), avenues for tie-ups and structuring considerations including implications of foreign direct investment (FDI) regulations.

Part B: In this section, we identify the principal business segments that will be served by the SP route and the manner in which this route will be expanded for broader ammunition procurement. This section will examine some of the technical, financial and other parameters.

PART A — SHORTLISTING OF OEMS, FDI RESTRICTIONS ANDSTRUCTURING CONSIDERATIONS

Shortlisting the OEMs

The MoD will shortlist OEMs entitled to participate in the strategic partnership model taking into account the quantum, range, depth and scope of technology to be transferred, the extent of indigenous content proposed, value addition to the proposed eco system of Indian vendors/manufacturers, measures to aid the SP in integrating platforms, plans to train skilled manpower and extent of future R&D planned for India.

Indian companies shortlisted to act as SPs are free to engage with any of the shortlisted OEMs to jointly finalise the techno-commercial offer to the MoD.

Under the SP route, an Indian company is entitled to submit only one bid in collaboration with a single OEM. An exception to this rule has been provided for segments with diverse platforms (such as helicopters) where potential SPs may submit responses with more than one OEM to have the best technology solution.

A minimum number of platforms (not exceeding 10-15% of the number of units being procured) are to be manufactured in the OEM’s premises. It is unclear whether this requirement may be waived or modified in relation to any specific system.

Potential Tie-ups with OEMs and FDI restrictions

The SP route envisages a tie-up between shortlisted Indian SPs and foreign OEMs for technology transfer, indigenous capacity building and assistance in training skilled human resources and other support throughout the life-cycle of the platform.

Such tie-ups could be in the form of joint ventures (JVs), equity partnerships, technology sharing, royalty or other arrangements between the companies concerned.

The applicant SP must be an Indian public company (as understood under the Companies Act, 2013) owned and controlled by resident Indian citizens.

This requires the management of such a company to be in Indian hands with majority representation on the Board of Directors. Furthermore, Chief Executive(s) of the SP must be resident Indians who are part of the Indian group owning and controlling the applicant.

For FDI purposes, calculation of foreign investment in the applicant SP must include:

the paid-up equity share capital held by the OEM either by itself or through its subsidiaries or nominees;

the paid-up equity share capital held by other foreign investors; and

the foreign investment held by an OEM or other foreign investors in accordance with (i) and (ii) above in any Indian company or limited liability partnership which is a shareholder in the applicant SP.

However, it has been clarified that for the calculation of foreign equity in the applicant SP, equity held by foreign portfolio investors (Category I and II only) and Indian mutual funds would be excluded.

Changes in ownership structure or shareholding pattern of the SP require prior approval of the MoD.

The ownership and control thresholds adopted under the SP model are consistent with the extant FDI policy. This means that the maximum permissible FDI in an applicant SP cannot exceed 49% (including indirect foreign investment). While it may not be possible to draw a very fine line here, the implication appears to be that overreaching affirmative vote rights and other operational control levers by the OEM will be frowned upon.

The rules, however, recognise that equity participation of foreign OEMs will not prevent other arrangements for sharing management rights in the JV mutually agreed between the SP and the OEM. It is unclear how far the Government will permit strong operational oversight and control rights in the JV, whether as a part of the JV agreement or other technology (and similar) agreements. There does not appear to be a “bright line” test for control. Therefore, there is some risk that OEMs will struggle to achieve a balance with their desired level of comfort in terms of operational oversight and governance and the need to ensure that these rights do not overstep the control threshold as understood under the FDI regulations.

In fact, to underscore the need for simplicity and clarity, the rules unequivocally state that no pyramiding of FDI in Indian holding companies or in Indian entities subscribing to the shares or securities of the applicant SP would be permitted. Aggressive structuring and back door financing options will not be looked at favourably as it appears that anti-avoidance structures will be resisted.

A business-friendly approach is evident from the flexibility provided to the applicant SP in relying upon its group company(ies) experience in an identified segment, where such a group company with requisite experience and expertise may synergise its capabilities with the SP by executing a deed of adherence providing the MoD and the SP an irrevocable right to access, enter upon and use its facilities for duration of the strategic partnership. However, in such situations, it has been clarified that the FDI restrictions on the applicant SP shall also apply to such segment group company. It is not clear if the group company will be subject to additional restrictions (e.g. on change in ownership/control or raising financing, etc.).

OEMs are expected to be jointly responsible, along with the SP, for certification and quality assurance of the platforms supplied to the MoD. Importantly, OEMs are required to provide a formal acceptance by their relevant governments in relation to the proposed technology transfer arrangements prior to the issue of a request for proposal (RFP). Such a commitment may also be supported by inter-governmental arrangements signed between the countries at the award stage in relation to the defence contract. It is unclear how this requirement will be met at the RFP stage. This needs to be monitored.

Using special purpose vehicles

SPs are allowed to incorporate project specific special purpose vehicles or use existing subsidiaries (SPVs) in respect of specific projects or contracts awarded by the MoD when procurement contracts are required.

The rules, however, provide that SP will be the primary contracting party with a clear restriction on assignment of such a contract while allowing the integration of the required system or systems by the SP or its SPV.

Shareholding of an SP in the SPV must be locked in for the term of the strategic partnership. A limited carve out is provided in the case of companies providing technology for a project or a contract. Such companies will be permitted a maximum of 49% ownership in such an SPV subject to ownership and control of such SPV continuing to remain with the SP.

The FDI restrictions applicable to SPs would also apply to such SPVs.

From a liability standpoint, the SP would have overall responsibility of performance to the MoD. The SP and the SPV would be jointly and severally liable in respect of the contract so awarded. It has been clarified that the SPV’s joint and several liability with the SP will be prorated to the extent of its workshare, as agreed at the time of approval of the SPV by the MoD.

PART B — CLASSIFICATION OF SEGMENTS ANDPARAMETERS FOR SELECTION OF SPS

Segments for SPs

There are identified segments in which strategic partnerships will be allowed. Presently, Chapter VII of the DPP 2016 only provides the following segments for which SPs can be formed:

Submarines

Fighter aircrafts

Armoured fighting vehicles (AFV)/ main battle tanks (MBT)

Helicopters

(collectively, Group 1 Segments).

However, it is interesting to note that a Task Force Report (TF Report) published by the MoD in December 2016 suggested the same segments for SPs and classified them as Group 1 Segments. Apart from the general parameters for selection as an SP in any of the Group 1 Segments, the applicant would also have to adhere to segment specific conditions. We are not covering these in detail as we expect these to be described in much more detail in the relevant RFPs.

In addition to the products mentioned above, the TF Report also mentioned a second set of segments which comprise of the following:

Ammunition, including smart ammunition (recommended by TF Report)

Metallic material and alloys (crystallised by TF Report but not immediately recommended)

Non-metallic material, including composites and polymers (crystallised by TF Report but not immediately recommended)

(collectively, Group 2 Segments).

Chapter VII of the DPP 2016 currently does not mention Group 2 Segments, however, the Group 2 Segments may be notified later by the MoD.

Selection parameters

Selection of SPs is subject to various parameters which are summarised below for both the Group 1 and Group 2 Segments. Apart from the following parameters, it is unclear whether selection of an SP will also be subject to verification and comparison by the MoD amongst bidders from each category (as suggested in the TF Report). A verification and comparative evaluation amongst bidders was suggested in the TF Report, but has not been incorporated into Chapter VII of the DPP 2016. Currently, it is difficult to envisage the timeline for the MoD to be able to select the SP for any category.

Sl. No.

Selection criteria

Group 1 Segment

Group 2 Segment

1.

Restriction on Segments

Only one SP per Segment.

Two (or more) SPs may be allowed by the MoD.

2.

Technical Gate

Demonstrable capability for integration of “System of Systems” i.e. integration of a system with multiple technologies of major systems like aircrafts, ships, chemical plants, power plants, automobiles, etc. as specified in the expression of interest (EoI).

Demonstrable that the applicant is an engineering and/or a process technology company having commercially supplied products.

3.

Financial Gate

No specific thresholds specified; would be indicated in the EoI/RFP.

The TF Report, however, suggests the following thresholds which may be indicative of what is to be expected in this Segment:

Turnover: a consolidated turnover of INR 40,00,00,00,000 (Indian Rupees Forty billion) for each of the last 3 (Three) financial years.

Revenue growth: consolidated revenue growth of 5% (Five per cent) per annum in at least 3 (three) of the last 5 (five) financial years.

Credit score: minimum credit rating (long term/issuer rating) equivalent to CRISIL/ICRA “A” (stable) as on the date of the application.

The TF Report has suggested the following thresholds:

Turnover: consolidated turnover of INR 5,00,00,00,000 (Indian Rupees Five billion) for each of last 3 (Three) financial years.

Assets: capital assets at gross book value should be INR 1,00,00,00,000 (Indian Rupees One billion).

4.

Other Conditions

Promoters and directors of the applicant SP and its group companies must not be wilful defaulters (as classified by the RBI).

In addition, the TF Report has prescribed the following additional conditions which have not been incorporated into Chapter VII of the DPP 2016:

that the applicant must show robust governance practices (including no qualifications in an applicant SP’s audit report)

thorough evaluation of the debt restructuring and non-performing assets of the applicant SP.

Same as TF Report suggestions for Group 1 Segments.

Rationale for focus under Segment 1

Chapter VII of DPP 2016 currently requires an SP to maintain focus on a core area of expertise with only one SP selected per segment. The ‘single SP per segment’ concept is aimed to foster economies of scale and prevent wastage and leakages which may increase the risk premium and costs for the applicant SPs due to competition.

Since Group II Segments are more bulk produced products, it is expected that two (or more) SPs for a particular Group II Segment may be allowed by the MoD.

Verification stage

The verification stage suggested by the TF Report envisages an on-site verification by an evaluation committee set up by the MoD. The assessment of an applicant SP in this stage will be based on the criteria mentioned below (on the basis of figures certified by a statutory auditor):

Return on invested capital (RoI) of the applicant SP (EBITDA divided by average invested capital): Average of RoI for last 3 (Three) financial years should not be less than 9% (Nine per cent); and

Debt divided by EBITDA for the applicant SP should not be higher than 3:1.

It is unclear why the TF Report recommended a verification, since it is safe to assume that compliance with all the financial, technical and other criteria would be required at the time of the contract award and later.

Comparative analysis and final selection of SP

While not incorporated in the DPP 2016, final stage as per the TF Report would include a simple comparative analysis done by a marking system of all the applicant SPs. The TF Report contemplated the following weightage for each of the criteria:

Criteria

Weightage

Technical

40%

Financial

40%

Segment Specific Conditions

20%

Comment

The current “Buy and Make” category of the DPP 2016 relies heavily on foreign OEMs to provide technology which is otherwise not available in India. The aim of the strategic partnership policy is to reduce reliance on foreign OEMs and develop indigenous capability in line with the “Make-in-India” drive. The strategic partnership policy aims to develop not only large scale private sector enterprises, but also Micro, Small & Medium sector enterprises.

“The content of this document do not necessarily reflect the views / position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com”

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